Not all low-cost index methodologies exhibit the same risks and opportunities

index methodologies

Over the past decade, investors and large institutions have been deserting expensive active fund managers in return for using their cheaper index equivalents.

According to Morningstar, investors in the US withdrew $USD204 million from actively managed investments (net) in the 2019 calendar year. However, low cost index funds continued to grow in popularity receiving (net) $USD162 million of new money. The transition away from active management into low-cost index funds has been happening for over a decade.

Whilst it is true that traditional market cap indexing has outperformed many professional managers over long periods of time, it does have its shortcomings, particularly in markets other than bull markets.

It is my thesis that investors would be well advised to employ a selection of fundamentally sound indexing methodologies. Doing so can reduce a portfolios risk and potentially expose it to higher future returns.

What are the recent stats of index versus active?

Index funds are popular for good reasons. As I have written about previously, index funds typically produce better returns over the long run and charge much lower fees.

For example, only 16% of active fund managers have produced better returns than the index over the past 15 years in Australia (and only 11% in the US). However, it is important to note that the same fund managers have beaten the market each and every year. In fact, active fund managers may only outperform for one or two years. Statistics show that their outperformance almost never persists for longer periods of time.

According to data published by S&P Dow Jones, 81 Australian fund managers where in the top quartile in terms of performance for the 2015 year. Only 11 out of 81 remained in the top quartile a year later i.e. 2016 calendar year. And only 5 out of 81 were able to string three good years together (i.e. were in top quartile in terms of performance for 2015, 2016 and 2017). It is clear that ‘picking’ an active manager that will outperform is a very difficult thing to do, as it is likely you will need to chop and change fund managers every 1-2 years.  

Three types of index methodologies

Indexing strategies typically fall into three categories:

  1. Traditional market cap indexing – this is the type that you are probably most familiar with and has been popularised by Vanguard since the mid-1970’s. Market cap indexing spreads your investment across an index proportionately according to a company’s value (compared to the index’s aggregate value). For example, if you invest in the ASX200, 8.2% of your money will be invested in CSL, 7.6% in CBA and so forth.
  2. Factor-based indexing – factor-based index methodologies uses measures other than a company’s market value (which is linked to its share price) as a means of diversifying your investment. These methodologies seek to break the link with price. The thesis is that price does not always accurately reflect a company’s risk and future returns. Examples of these mythologies include fundamental indexing and Dimensional.
  3. Equal weight indexing – This is probably the most unsophisticated indexing approach. It invests an equal amount of your money in all companies that are included in an index. For example, if you invest in the ASX 200 index, then one 200th of your monies will be invested in each of the top 200 companies.

How have they performed recently?

The chart below compares the relative performance of the abovementioned three index methodologies for the 5 years ended 18 June 2020 (fundamental indexing has been selected as an example of a factor-based methodology).

Equal weight has performed best with a price return of 4.7% p.a., then traditional indexing at 1.4% p.a. and fundamental indexing has returned a loss of 1.6% p.a. This analysis excludes income (dividend) returns.

index methodologies

Total returns (growth plus income) for the 5 years to the end of May 2020 were 5.94% p.a. for equal weight, 4.04% p.a. for traditional indexing and 2.84% p.a. for fundamental indexing.

You would be excused from concluding that equal weight is the best methodology  

Simply selecting the methodology that has produced the highest historical return isn’t always the most sensible approach. Instead, it is important to understand what has driven past performance. Once you understand that, you will then be able to form a view in respect to whether past performance is likely to be repeated.

Why has equal weight beaten traditional indexing?

A large part of this has to do with the lower exposure to the financial services sector and big 4 banks in particular. The equal weigh index invests 17.4% in financials compared to 27% for the ASX200. But the big for 4 banks are mostly responsible for the poor returns. Three of the big 4 have fallen in value by around 43% over the past 5 years (being ANZ, nab and Westpac). CBA has fallen 25%. Given these 4 stocks constitute approximately 20% of the traditional index (but only 2% of the equal weight index), they are almost certainly responsible for the underperformance compared to equal weight.

Why has fundamental indexing underperformed traditional indexing?

The reason fundamental indexing has underperformed traditional indexing is that it is underweight in the healthcare sector e.g. only 4.8% is invested in healthcare versus 15.1% for the index. The main cause of this is CSL. The fundamental index only has 1.2% invested in CSL compared to 8.2% for the traditional index. CSL’s share price has increased by 230% over the past 5 years, so investing less in it has dragged on returns. In addition, Healthcare has been the best performing sector over the year to May 2020 – returning over 28%.

The aim of fundamental indexing is to skew investments away from businesses that appear to be overvalued. Given CSL’s price-earnings ratio is around 45 times (more than double the general market level), it is no surprise the fundamental methodology results in a materially underweight position in CSL. The big question is can CSL continue to increase its earnings and/or valuation at the same rate over the next 5 years, especially if the US economy slows? 

Your starting valuation has a strong inverse relationship with long term returns

A large amount of empirical stock market studies demonstrate that your starting valuation is a reliable predictor of long-term returns. That is, if you invest when markets are “cheap”, you can expect above median investment returns over the long run (e.g. 10 years).

However, if you invest when markets are expensive, and therefore future returns are already reflected in the current value, then the prospect of receiving below median returns are high.  

Markets tend to switch from growth to value quickly and sharply

Over the past decade, the market has rewarded growth investors and as a result, punished value investors. US companies such as Amazon, Tesla and Netflix are great examples of this – all trading on price-earnings ratios of more than 100(!) – except Tesla – it’s not even profitable. Australian unlisted tech business Canva, was recently valued by investors at $8.7 billion. Its annual revenue is circa $50 million and makes less than $4 million in annual profit! Am I crazy or are these valuations insane?!

At some point, the market will start to reward companies with strong cash flows and profitability, low debt and stable dividends i.e. sound fundamentals. This is exactly what happened in the early 2000’s at the end of the dot-com bubble. 

Investing in equal weight invites you to take two positions

Firstly, that recent winners and loser will cease winning or losing. If you invest $200 in an equal weight product, then $1 will be invested in Westpac. If Westpac’s share price increases by 20%, your shareholding will be worth $1.20. When it comes time to rebalance (which occurs each quarter), the equal weight fund will sell down that exposure back to $1. There is little logic behind this. 

Secondly, by investing that same amount in each of the top 200 companies, you will resultantly have more money invested in smaller companies – compared to the broad index.  Therefore, you are taking a position that suggests you believe small-cap companies will outperform large-cap companies. That might not prove to be true, particularly if the economy weakens.

It is for these two reasons that I’m not attracted to the equal weight methodology. In addition, it is my view that the unique set of factors which conspired to produce outperformance over the past 5 years are unlikely to be repeated.

Astute portfolio construction can increase returns

Many commentators suggest nab, ANZ, Westpac and to a lesser extent CBA represent good value at the moment. That is, the suggestion is that perhaps all potential risks are fully reflected in their current prices. I tend to agree with this thesis. As such, their future returns over the next 5 to 10 years are likely to be above median levels.

Importantly, there is robust evidence that confirms that in the long run, market valuations and investment returns do eventually revert to their long-term mean. This assists us in forecasting future returns. According to Research Affiliates financial modelling, fundamental indexing is expected to outperform developed market indexes by circa 4% p.a. over the next decade.  

Nearly 6 decades of historic data shows that value and quality strategies outperform in more uncertain economic climates (see Table 4 here).

If you agree with this thesis, then perhaps there is merit in considering diversifying indexing methodologies.

Sit on the fence

Diversifying is proven to be a wise financial strategy. This also extends to ruled-based, low-cost indexing methodologies too. I believe that you should employ a number of methodologies to hedge your bets.

At this time, I am keen to have greater exposure to value and quality methodologies as I feel it exposes a portfolio to lower risk and potentially higher future returns. But that is not to say that I have abandoned traditional market cap indexing. It still has a role to play in portfolio construction.